Ringing a Bell at the Top?

Investor demand for emerging-market bonds is driving the cost of insuring against debt defaults below industrialized governments for the first time.

Credit-default swap prices from Turkey to Indonesia are falling as bonds rise amid signs that their economies are recovering faster than developed nations. As the U.S. and U.K. borrow record amounts to fund bank bailouts and stimulus, Brazil, Russia, India and China have $3 trillion in reserves, up 19 percent from January 2008 and now 43 percent of the worldwide total, data compiled by Bloomberg show.

The annual cost of protecting holdings in Turkey’s bonds fell by half to $200,000 per $10 million for five years, or 200 basis points, sinking below New York City swaps for two weeks starting July 22, Bloomberg data show. Indonesia debt insurance dropped below Michigan the next day. Brazil swaps just had their biggest four-month slide ever. For China, protection is near the cheapest in a year. Eleven years after Russia defaulted, investors want less to insure its debt than California’s.

“This would have been impossible to imagine a year ago,” said Dmitry Sentchoukov, an emerging-market credit strategist at Dresdner Kleinwort in London. “Now it’s clear emerging economies are going to outperform the Group of Seven in growth, and that makes investors comfortable with the idea that developing countries can be priced richer than developed.” Swaps on California have risen more than three-fold in the past year as its credit rating was lowered two levels to Baa1 by Moody’s, the same level as Russia, which reneged on $40 billion of sovereign debt payments in 1998. Russian default swaps are near a 10-month low of 255 basis points, about 20 basis points less than contracts linked to California. The former Soviet state’s 7.5 percent, 2030 dollar bonds are at a 2 1/2-month high of 101.74 cents on the dollar.

“If California is issuing their own dummy currency in the form of IOUs, that’s not a good sign,” said Augustus’ McNamara.

Where we've been is not necessarily where we're going. It would be interesting to see a contra-trend, contra-popular opinion dollar rally. If the ECRI is correct, a strong cyclical rebound is coming in the U. S. Also cyclically, inflation declines as the economy begins to grow after a strong downturn, and we are starting from negligible inflation now. So, real interest rates in the U. S. are already attractive and could rise.